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Study projects more gains for stocks: Should you listen?

May 28, 2013

| MoneyRates.com Senior Financial Analyst, CFA

What's a diligent money saver to do?

For years you've been cautious with your money, living within your means and salting away cash in a nice, safe savings or money market account. Then along comes a Federal Reserve that seems almost hostile to savers. They encourage borrowing with record low mortgage rates. They all but eliminate the interest on savings accounts and other deposits. And finally, here come economists from the New York branch of the Fed with a study that claims stocks have never looked more promising -- even though prices recently hit an all-time high.

Should you abandon your principles, take your savings on a spending spree and throw the remainder into the stock market? Hold on before you go crazy -- you might be glad for your conservative ways after all.

What the study said

Economists from the New York Fed recently published a study called "Are Stocks Cheap? A Review of the Evidence." This study looked at 29 different predictive models and concluded that the projected excess return of equities over bonds was more attractive than it had been at any time in the past 50 years. The consensus of these models was that stocks should produce a 5.4 percent return over bonds this year, and that similar levels of excess annual returns should continue over the next five years.

Significantly, the previous highs for predicted returns using this methodology came in November 1974 and January 2009. Those were near the bottoms of two historic bear markets, meaning they would have indeed been pretty good times to invest in stocks.

The New York Fed's website posted a disclaimer saying that the paper does not necessarily reflect the opinion of the Federal Reserve. However, by posting it on their website, they obviously feel it deserves attention.

Reasons to be cautious about stocks

As compelling as the study may seem, here are a couple of notes of caution:

  1. Stocks look good primarily because interest rates are so low. The Fed's study acknowledges that if Treasury yields were at normal levels, the attractiveness of stocks would be well below historical average. The key question is, can the economy improve enough to support a stock market rally without interest rates returning to more normal levels?
  2. The study was based on December 2012 data. As of mid-May, stock prices were up about 16 percent since then, meaning they may already have used up a couple years' worth of those excess returns.

The stock market has already risen sharply on the expectation that the economy will get better. That leaves stocks without as much to gain if that expectation becomes reality. Meanwhile, economic improvement would be likely to bring rising interest rates, which would actually create some resistance to the stock market. In that scenario, stock owners might face dwindling returns -- while people with healthy savings accounts would be sitting pretty.

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